The Common Sense Investor

Nothing can cause a person more headaches than a bad debt. Examples of bad debt might include credit cards, personal loans, and department store credit which could all negatively affect your life and could even possibly lead you to bankruptcy.

The common sense consumer should make a conscious effort to avoid taking on bad debt and letting it get out of control. Ideally, one should avoid most debt with an interest rate above inflation. However, in some cases, such as when buying a home, tax rebates and cost-effectiveness (compared with renting) make it wise to take out loans with higher interest rates.

The really big problem with high-interest debt is that it diminishes the value of your current income. All your financial resources get thrown at paying off interest. At the end of the day, you have less money to spend or invest. Instead of putting your money to work to make more money, you’re giving your money away to some huge corporation.

So what makes a debt a bad one?

A debt should be considered bad if it negatively affects your financial future or your psychological well-being. Some examples include financial obligations that last longer than the purchase item, debts taken to purchase quickly depreciating items (new cars), loans with interest rates that are more than 5% above inflation, credit that extends you beyond your ability to meet other monthly expenses, and debts that do not give a return toward increasing your net worth.

As a side note, it should be remembered that not all debt is bad. Sometimes debt can be used successfully to increase net worth and to empower investing. Such debt, when used wisely, should be considered good debt.

Financial experts are one in recommending that you avoid bad debts like the plague or at least to keep borrowing to a minimum (and under control). The general advice is that your total debt should not exceed ten to fifteen per cent of your take home pay, excluding mortgages. Other experts also suggest that debt should not go over 25 per cent of your disposable income.

If you do overextend what will happen is that you will be pushed to your absolute limit to repay your debt while at the same time maintaining your living expenses. Any sudden incident (a job downsizing, divorce, an accident, theft) will have tragic results to your finances and will most likely result in a credit crisis.

The first thing you should do if you want to get rid of the bad debt is to rein your purchases in. Stop making impulse purchases especially on credit. Most debt can be avoided if you can just learn to live within your income. Instead of relying on instant fixes like loans or credit cards to buy items like clothes or luxury, you should learn to delay the gratification and save for the purchase. You should also learn to pay cash so that the interest penalties do not compound any further (in the case of credit cards, you are not only paying for the principal borrowed you are also paying interest based on the sum of the original debt plus the new one you got).

As a strategy for dealing with debit, start by listing all of the debts that you have and then identify the amount of money that is paid for the monthly servicing (interest) of the debt. You should begin paying off the debt with the highest interest. If two debts are at the same interest, then pay-off the lowest balance owed (you’ll feel a sense of achievement as you completely pay-off each account). By being intentional about eliminating your high-interest credit, you are swiftly but methodically eliminating the bad debts in your life.

But this doesn’t mean that you should put all of your money to debt servicing. You should still apportion a percentage of your income so that if an emergency happens you still have the resources to get through it successfully.